UK: New Incentive For Charitable Legacies In Wills

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The Government has introduced a new inheritance tax
("IHT") relief for individuals leaving at least 10% of
their net free estate on death to charity ("the 10%
Test").1

As has always been the case, the gift to charity is completely
free of IHT. However the effect of the new relief ("the
Relief") where it applies is that the remainder of
the deceased's net free estate going to the testator's
non-charitable beneficiaries bears IHT at the lower rate
of 36%, instead of at the normal IHT rate of 40%.

The Relief applies to deaths on or after 6 April 2012.

The Relief will be mainly relevant to the deceased's free
estate, that is the part of his estate that he is free to leave by
will. However, in certain circumstances (explained below) the
Relief might also be relevant to other "components" of
the deceased's estate, such as trust property in which he had a
so-called "qualifying" interest in possession (ie broadly
speaking, a trust from which the deceased had the right to receive
the income and which – usually – will have been
established before 22 March 2006 or under a will).

How the relief works

The 10% Test (for determining whether the Relief applies) and
the Relief itself apply separately to each of three components of a
person's estate on death. The component to which the Relief
will in practice most often be relevant is a person's free
estate (referred to in the legislation as "the general
component") because it is from the free estate that gifts are
most likely to be made to charities.

The second component of a person's estate to which the
Relief can in principle apply is his/her jointly owned estate which
on his/her death automatically passes by survivorship to the other
joint owner(s). In this case the relief can apply if the surviving
joint owners redirect some or all of the property to a charity by
way of a deed of variation.

The third component of the deceased's estate to which the
Relief can in principle apply is to property in which the deceased
had a qualifying interest in possession at death (that is the right
to receive the income) which will usually be under a pre-22 March
2006 lifetime trust, or under a will trust qualifying as an
"immediate post death interest". In such cases, the
Relief could apply if all or part of the trust fund passes to
charity on the death of the individual life tenant in question.

If the 10% Test is satisfied for one component by reason of
charitable gifts made from it, then the basic position is that the
Relief applies only to that component. In other words the 10% Test
is applied and the Relief is received for each component separately
(although this is subject to the possibility of electing for one or
more components to be "merged" if the charitable gift is
large enough – see further below.) In determining the value
("the Baseline Amount") of the relevant component of the
deceased's estate for the purpose of working out whether the
10% test is satisfied in relation to that component the following
deductions are made from the component in question

(a) any part of the component in question which qualifies for
IHT exemptions (such as the spouse exemption) or reliefs (such as
business property relief and agricultural property relief)
applicable to the component in question.

(b) the deceased's nil rate band. Where the deceased's
estate comprises more than one component the nil rate band is
allocated pro rata between the different components. If fully
available, the nil rate band is currently £325,000. Sometimes
it will be more – up to £650,000 if the deceased has
"inherited" a so-called transferable nil rate band from a
pre-deceased spouse or civil partner. However, a deceased
person's available nil rate band is reduced by lifetime
chargeable gifts (mainly gifts into trusts) or potentially exempt
transfers ("PETs") which become chargeable. (PETs are
lifetime gifts to individuals or which benefit individuals. They
become chargeable if the deceased's death occurs within seven
years of making the gift.)

The Baseline Amount for the component (including the value of
the gift to charity) is then compared with the amount going to
charity and if the charitable gift is at least 10% of the Baseline
Amount then the Relief will apply to the component in question with
the result that the IHT rate on the remainder of that component (ie
the part not going to charity) will be 36% instead of 40%. Note
that in working out whether the 10% Test is satisfied in relation
to the component in question only gifts to charity from the
component on the deceased's death are counted.
Lifetime gifts to charity from the component are not
counted.

In the (relatively rare) cases where IHT is deferred on death,
for example under the socalled conditional exemption for certain
kinds of heritage property, but later comes into charge, say on a
subsequent sale of that property, any of the Relief which is unused
at the death (ie where the charitable gift was more than 10% of the
Baseline Amount) is not available in relation to the deferred IHT,
which will therefore be chargeable at the full rate.

The 10% Test is all or nothing – if the share of the
component in question is just under 10% there is no taper or
similar mechanism to allow reduced Relief.

The relief applies automatically and without the need to make an
election – although it is possible to "opt-out" of
the relief – see below.

Two simple examples of how the relief works, assuming the
deceased left only free estate, are as follows:

Extending the relief to other parts of the estate on death

Situations may arise in which the gift to charity from one
component is large enough potentially to satisfy the 10% Test not
only for that component, but also for one or more of the other
components of the deceased's estate from which there are no
gifts to charity, or from which any charitable gifts fail to
satisfy the 10% Test. In such cases the deceased's personal
representatives and the "appropriate persons" in relation
to the other "eligible" component(s) may elect to merge
the component(s) to enable the Relief to apply to both or all of
them.

A simple example of how this would work is set out below:

Where the deceased died having made a gift with reservation of
benefit during his lifetime (for example by giving a holiday
cottage to his children but continuing to stay there) the property
subject to the reservation ("GROB property") is treated
as remaining within his estate for IHT purposes. Similarly to the
manner in which an election may be made to merge different
components of the deceased's estate, an election can also be
made to merge one or more components for which the 10% Test is
satisfied with any GROB property deemed to be comprised in the
deceased's IHT estate. If the charitable gift is large enough
this would enable the Relief to apply to the GROB property as
well.2

The persons (defined in the legislation as "the appropriate
persons") who may make an election to merge different parts of
the estate are, for the free estate, the deceased's personal
representatives, for GROB property, the person in whom the property
is vested, for property passing by survivorship the person(s) to
whom it passes and for property in which the deceased had an
interest in possession, the trustees of the trust in question.

Deeds of variation to procure the relief

In practice the deceased will not generally know in advance the
value of his/her net death estate. Therefore there might be some
cases in which a gift left by will, contrary to the testator's
intentions, turns out to be insufficient to satisfy the 10% Test.
Or the beneficiaries might in any event decide that they would like
to vary their entitlements under the will in favour of charities
whilst also reducing the IHT rate on the remainder of the estate
going to non-charitable beneficiaries. In such cases it is in
principle possible for the affected beneficiaries (provided they
are all adults with full capacity) and personal representatives to
enter into a deed of variation in favour of charities in order to
ensure that the 10% Test is satisfied. The deed of variation must,
however, be notified to the charities in question in order for it
to be effective for IHT purposes.

Disclaiming the relief

The Relief is available for gifts to charity of any kind of
property. In some cases, however, the gifted property might be
difficult to value (for the purpose of working out whether the
Relief is available) or there might be other administrative
expenses associated with the gift. Such expenses might outweigh the
benefit of the Relief. An election may therefore be made under the
legislation to "opt out" of the Relief. The election is
made separately in relation to each component and is made by the
same "appropriate persons" for the component in question
as would make a merger election, as explained above. Any opt out
election must be made within two years of the death and is
revocable within the period of two years and one month from the
death.

Non-domiciliaries

Non-UK assets belonging to non-UK domiciled individuals, or held
in a trust established by a non-domiciliary, are outside the UK IHT
net. These assets are left out of account in working out whether
the 10% Test is satisfied so that non-UK domiciliaries can receive
the relief on their UK estates, provided they leave at least 10% of
their net UK estate to charities (In other words, a non-UK
domiciliary's non-UK estate is left out of account in
determining the Baseline Amount).

How should my will be drafted to secure the new relief
for gifts to charity?

Since it will be impossible to know in advance the size and
value of your net estate at death it will also be impossible to
know in advance the size of the gift to be left to charity in order
to secure the Relief. The best way therefore to ensure that the
Relief will apply is by providing for a formula based gift to
charity in your will. Rather than stipulating a fixed amount, the
gift would specify the percentage of your net estate (at least 10%
to secure the Relief) that is to go to charity.

It may also be desirable that the gift should be in the form of
a specific legacy in your will, rather than being expressed as a
share of residue. Expressing the gift as a share of residue can
give rise to complications. In particular in some cases it would be
necessary to "gross up" other chargeable parts of the
estate (specific legacies or share of residue) going to non-exempt
beneficiaries such as children, which would in turn increase the
IHT on those chargeable parts.

Another option would be to include in your will a discretionary
trust with a letter of wishes to your will trustees requesting that
following your death they make an appointment from the trust to
charity of such an amount as will ensure that the Relief will
apply. The discretionary trust can be in the form of a specific
legacy or a share of residue. This might be appropriate for someone
who wants to give just enough to qualify for the lower tax rate.
The disadvantages are that even the discretionary trust fund itself
might not be large enough to qualify for the relief (for example,
if the discretionary trust is of residue and the will contains
large specific gifts to non-charitable beneficiaries.) There could
also be conflicts of interest if the will trustees are also
beneficiaries who might be unwilling to give up part of their
benefit under the will to charity.

A further option might be to leave a legacy of a specific amount
or asset which is likely to meet the 10% Test. This
ensures that the charity will get the gift but of course does not
guarantee that the 10% Test will be met. It might on the
other hand mean that the gift is larger than necessary for purposes
of the Relief, which might in turn give rise to a risk of claims
against the estate by non-charitable beneficiaries.

Finally, the testator might leave a legacy to a non-charitable
beneficiary (such as his/her spouse or child, or the executors of
his/her will) with a letter of wishes requesting that all or part
of the legacy be redirected to charity so as to secure the Relief.
This ensures that only the amount needed to secure the Relief
passes to charity. It also means that the testator can change the
ultimate charitable recipient if desired simply by writing a new
letter of wishes. On the other hand there is still the problem that
the 10% Test is not certain to be satisfied. Moreover, there is no
legal obligation for the beneficiary named in the will to pass the
amount of the gift on to the charity.

Points to consider when making your will

Points to consider in connection with the Relief when making
your will include the following:

do you want the gift to result in the Relief applying only to
your free estate? Or, if you also have jointly owned property
passing by survivorship, or a qualifying interest in possession in
a trust, or a reservation of benefit in previously gifted property,
would you want the gift to be large enough to allow elections to be
available for those other elements of your estate so as to enable
the Relief to apply to them as well?

do you want the gift to charity to have a minimum or maximum
value?

do you want the gift to charity only to take effect on the
death of your spouse or civil partner?

do you want the gift to charity to take priority over other
legacies (in the event that for any reason your estate were to
prove insufficient to satisfy all legacies)?

do you wish the gift to charity to take effect in any event,
even if the Relief does not apply?

Conclusion

The Relief is a relatively modest proposal to incentivise
charitable giving by will. There is a particular advantage for some
testators; those who have already made gifts to charity in their
wills representing at least 4% of their net estate should be able
to increase the charitable legacy up to 10% of their net estate
without reducing the share of the estate passing to the other
(non-charitable) beneficiaries. However, whatever your reasons for
wishing to make gifts that bring the Relief into play, it is clear
that some thought needs to be given in individual cases to the best
way of achieving this.

Footnotes

1 This follows on from the Government consultation
published in June 2011 – see further our briefing note dated
30 June 2011 entitled "Government proposes new incentive for
charitable gifts at death". The provisions as enacted and
which we explain in this briefing note, differ in certain respects
from the original consultation proposals on which our previous
briefing note was based

2 The 10% Relief cannot apply to the GROB property in its
own right because this is property that has been gifted by the
deceased in his lifetime and is not available for charitable giving
on his death – it is onlydeemedfor IHT purposes to be comprised in his estate at
death.

The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.

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